The desert dollar industry

January 1, 2021

Jessie Smith, who owns a dusty motel in Beowawe, Nevada, had to turn away customers yesterday. No vacancy, Smith told the recent arrivals, the first time she has uttered those words since she bought the motel twenty years ago.

These days, the desert is swimming in cash... literally. Over the last six months, a booming business in illegal cash storage has sprung up in Nevada, New Mexico, and Arizona where analysts estimate that $30 billion worth of $100 notes have been hidden. By day, smugglers drive deep into the desert, SUVs loaded down with suitcases full of Ben Franklins. Once they've found an ideal spot, they wait till the sun goes down and frantically dig a hole, only to drive away the next morning with nothing but the cache's GPS coordinates and a drone or two to guard it. When asked about the sorts of people staying at her motel these days, Smith shrugs. "I don't ask who they are and they pay cash."

This is life in the Great Deflation. What began as a steady disinflation early last decade (a decline in the global rate of inflation) slowly turned into all out deflation by the turn of the decade. In response, central bankers around the world simultaneously increased their inflation targets from 2% to 4% and fully re-loaded their quantitative easing programs. To their embarrassment, consumer prices only continued to decline, crescendoing into what the press has dubbed hyperdeflation; annual global price declines of 2-3%. The Fed is currently in its fifth round of QE and, along with most central banks, has kept its key interest rate at the effective lower bound of -1.25% since 2019. To no avail.

Consensus among central bankers is that -1.25%, and not 0%, is the lowest interest rate that the public will endure before converting deposits into 0%-yielding cash. This level emerged as the consensus when the Swiss National Bank reduced rates to -1.5% back in 2018. A stampede into Swiss banknotes ensued. When the Bank dialed the rate back to -1.25%, the Swiss public re-deposited notes back into their bank accounts. Since then, no central banker has dared reduce rates below this magic level. If they did, they'd risk losing control of monetary policy (as if they haven't already) as well as causing a run on the banking system.

But wait. The world's newest monetary experiment is about to be unveiled...

Throughout 2019 and 2020 the world's monetary architects have been steadily dismantling effective lower bounds in many large economies, giving central bankers, until now stuck at -1.25%, the ability to reduce interest rates deep into negative territory. Many say that the world is on the cusp of something so new that we don't even have a word for it. The opposite of disinflation (disdeflation?), the dawning phenomenon of gradually declining deflation is being dubbed by the econblogosphere the Great Reflation. Some are forecasting that we'll soon be moving back up to -2 or -1% deflation... maybe even zero.

The Europeans started to dismantle their lower bound in 2019. They did so by having the ECB cancel all 500, 100, and 50 notes, leaving only the lowly 20 to circulate as the eurozone's highest denomination bill. And when a new 20 euro note was issued in January of last year, the ECB doubled its surface area from 72x133 mm to a cumbersome 108x200 mm. A standard suitcase now only fits half as much raw value, thus burdening noteholders with extra storage and handling costs. Even when folded in half, a single 20 note no longer fits snugly into a pocket. Which means that when the ECB drops rates into deeply negative territory (which it is expected to do at its next meeting), the European public probably won't bother converting deposits into clunky cash.

The U.S. was soon to follow. Unlike Euro notes, American bills are 70% cotton. So when the Fed first floated the possibility of removing $100 and $50 denominations from circulation last year, the cotton lobby exerted enough pressure that Fed officials decided to rethink their strategy. Instead of withdrawing $100s and $50s, the Fed asked Congress to make mass cash storage illegal. As of July 2020, any member of the public caught holding more than $1000 in bills risks having their stash confiscated, with corporations and financial institutions facing cash limits of their own. In theory, this should allow the Fed to set deeply negative interest rates.

Which explains why Nevada's deserts are being punched full of holes. The $1000 limit, combined with the possibility of deeply negative rates next year, means that storage of 0%-yielding paper has the potential to be incredibly profitable. To combat the so-called desert dollar industry, the U.S. Secret Service's counterfeit currency team has been retasked with patrolling vast empty patches of desert. So far their raids have had mixed success; smugglers have been diverting their hoardes across the border into Mexico or Canada. New legislation is being tabled to restrict cash exports and should be passed later this month. In any case, the significant costs that smugglers face in evading the Secret Service means that the Fed should be able to safely bring rates to -3% or so at its next meeting without facing mass flight into paper dollars.

Despite having dismantled its lower bound, the Fed held back from a rate cut at its recent policy meeting. Why? There is a growing faction in the Fed that says that reducing interest rates could very well prove disastrous. Not only would a cut not stoke inflation, it could exacerbate the existing hyperdeflation. To replace hyperdeflation with inflation, you need to raise interest rates, not drop them, claim members of this faction. Ratchet the interest rate up to 3% and arbitrage dictates that a gentle inflation will be restored. After all, if the Fed is compensating investors with a 3% return on its highly-liquid risk-free liabilities, then those investors will be content with an expected decline in the purchasing power of those liabilities, say a 1-2% inflation.

Once a taboo idea, the ongoing inability on the part of central banks to reign in deflation has brought this sort of turn-the-wheel-left-to-go-right thinking into vogue. Not only are central bankers finding it increasingly difficult to understand their traditional interest rate tool—it may not do what they always thought it did—but bond traders have been thrown into confusion. For years, the ECON 101 courses they learnt in college taught them that a reduction in interest rates leads to higher prices, not lower ones. Now they're not sure.

Jessie Smith, however, is 100% sure where she casts her lot; whichever direction keeps the cash flowing into Nevada. She's hoping that the Fed plunges rates to -5% next year, which would only increase her customers' incentives to store cash. As for a hike back into positive territory, the thought makes her shudder. Why hold 0% cash when you can earn 2 or 3% in the bank? Nevada's desert, now full of cash, would rapidly return to normal, and Smith's hotel would go back to having vacancies again.

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